Tokenization as Alternative Financing: Revolutionizing Real Estate in an Era of Rising Interest Rates

Originally published 11/8/2023

Introduction:

In the ever-evolving landscape of real estate financing, a notable transformation is occurring through the concept of tokenization. Interest rates are climbing and understanding how tokenization serves as an alternative financing method for real estate is of paramount importance. This article delves into tokenization and emphasizes the role of platforms like RedSwan CRE in shaping the future of real estate investments.

Real Estate Financing:

In traditional real estate individual buyers tend to pay a down payment along with taking out a mortgage on a home. For commercial real estate developers, oftentimes they put up some equity to go with a loan from a bank. In a recent interview with RedSwan CRE’s CEO Ed Nwokedi, he explains that as interest rates rise, cap rates go up, meaning that property values lower. This results in higher borrowing costs and risky situations for existing loans.

Let’s walk through an example. Say a $50M multi-family property has the following structure:

• Sponsor’s Equity: 15% ($7.5M)
• LP Investors’ Equity: 35% ($17.5M)
• Loan from Bank: 50% ($25M)

In this scenario, the loan from the bank tends to come with covenants such as a Loan-to-Value (LTV) of preferably less than 80%, meaning the loan needs to be worth a maximum of 80% of the value of the property. Should interest rates rise, the sponsor and LP investor’s equity values drop and the loan is in distress. Supposing the property value drops from the original $50M value to $30M. This puts the GP in a position to have to inject more equity into the cap table ($20M) to prevent the loan from going past the 80% LTV threshold which could risk foreclosure.

Tokenization:

Real-world assets are being represented on the blockchain with what is called a security token. This is a digital representation of ownership in pre-IPO equity, debt, real estate, venture capital LP rights, or any other security. In the previous example, tokenization could afford a GP an alternative option to that of putting up more equity. The GP could offer those $20M worth of equity as a security token offering (STO) to LP investors. This would effectively remove the bank from the equation and result in less risk for the property. In addition to token holders investing at a discount, RedSwan CRE’s sponsors often even offer preferred equity to those token holders meaning prioritized payouts.

Aside from the opportunity to invest in a property at a much lower barrier to entry and de-risking an asset, tokenized investors will also benefit from liquidity optionality. While investors may want to hold their investment for a prolonged period of time to reap its potential growth, real estate has a notorious reputation for keeping investors locked into a property until its sale. For investors that need cash sooner than that it’s historically been a challenge to find someone to sell their position to or for GPs to redeem those shares. Via tokenization, an investor may be able to list their tokens for sale on an alternative trading system (ATS) or exchange and find a complete stranger willing to buy them.

What about compliance? Not a problem, the exchange or ATS is charged with conducting KYC/AML checks along with any other necessary paperwork before investors are to interact with securities on their platform.

Real Estate Activity, Financing Costs, and Processes

As mentioned above, increased interest rates can lead to a more expensive cost of capital, specifically for those already involved in an adjustable-rate mortgage or loan. Pairing this with the number of intermediaries involved in a transaction may result in less people willing to participate in the real estate market, slowing down activity and overall market growth. RedSwan shared that a typical transaction can take 6 to 9 months to execute, which can leave the transaction exposed to changes in interest rates or other risks.

Because of investors participating as LPs and smart contracts, financing costs may drop significantly both monetarily and in terms of time when considering the removal of some intermediaries along with the removal of debt servicing. This benefits both the investors and the real estate developers involved as smart contracts can handle rent collection, profit distribution, and property management to name a few processes.

When a GP has 10 investors to cut checks to, it’s not a terribly difficult feat. However tokenization may enable GPs the ability to have thousands of investors without increasing back/middle office costs, such as distributions. Traditionally, GPs may have to account for address changes to send checks to, bank account changes to wire to, or even paperwork when approving sales of LP shares/ onboarding new investors. With security tokens, GPs can send distributions to thousands of investors at the push of a button via USDC to their respective wallets. Investor and wallet information automatically updates when tokens are transferred from one investor to another. Simple.

Conclusion

The real estate market has suffered from increased interest rates at multiple levels, from increased financing costs to increased default risk to lowered real estate market activity overall. Blockchain technology is transforming this asset class, along with others, via tokenization. This allows GPs/sponsors to refinance existing capital stacks by replacing bank loans with LP investor equity, removing interest rate risk and reducing financing costs in general. In addition to saving on cost of capital, RedSwan CRE is leveraging tokenization to allow more investors to participate at lower investment minimums with enabled liquidity. Thanks to tokenization, the number of investors will not increase back/middle office costs and complicate processes for their sponsors, in fact tokenization may even reduce them.

Everything in this article is for informational purposes only. Nothing in this article should be taken as financial advice or as an inducement to purchase or sell any security. Nothing in this article should be used as legal advice. Always do your own research before making any decisions regarding financial transactions of securities.